Investment Compass – Recession Fears

The past three months have been the toughest for<br /> investors since the last quarter of 2008 when the financial crisis<br /> deepened after the collapse of Lehman Brothers. When the crisis and<br /> corresponding recession ended in 2009 it was believed by many that with<br /> governments and central banks around the world united in maintaining an<br /> accommodative economic policy the financial storm had passed. Instead,<br /> what has happened is that the financial crisis has gone from being a<br /> mortgage debt crisis to a sovereign debt crisis. Rather than things<br /> getting back to normal, the global economy has been thrown into the<br /> much talked about new normal.

Navigating a Sea of Opportunity

Recession Fears: What’s an
investor to do?

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The past three months have been the toughest for investors since the
last quarter of 2008 when the financial crisis deepened after the
collapse of Lehman Brothers. When the crisis and corresponding
recession ended in 2009 it was believed by many that with governments
and central banks around the world united in maintaining an
accommodative economic policy the financial storm had passed. Instead,
what has happened is that the financial crisis has gone from being a
mortgage debt crisis to a sovereign debt crisis. Rather than things
getting back to normal, the global economy has been thrown into the
much talked about new normal.

The phrase “new normal” is used to denote a new era in which economies
grow much slower than what many had become accustomed to. The reason
for this period of slow growth results from the need by consumers and
governments alike to begin paying down the massive accumulation of debt
that we witnessed over the last few decades. So, rather than investing
and consuming, consumers and governments are cutting back.

Notably missing from the over indebted list are corporations. In fact,
seldom in history have corporate balance sheets been as pristine as
they are now, with cash representing a record high percentage of
corporate assets. The borrowing capacity and incentive to borrow for
corporations is also significant with interest rates at their lowest
since the 1950s. Corporations can now borrow cheaply for expansion,
stock buybacks or for acquisitions of competitors.

Interest Rates

As usual, the arguments from the economic bears are easier to observe:
European debt crisis, deleveraging consumers, Asian slowdown, etc.
After all, it is easier to see the dangers in volatile times than the
opportunities. However, the optimists point to such metrics as the
yield curve (the relationship between short term and longer term
interest rates). When short term interest rates are equal to or exceed
longer term interest rates a recession has often followed. Generally,
in such an interest rate environment, lending activity tends to decline
as the profitability that comes from it erodes. This acts as a brake on
the economy.
If we look at the state of the yield curve as shown in the chart below,
we can see that we have the steepest yield curve in two generations.
However, as is usual with the capital markets, there is a “but this
time is different” aspect to note: the central reason that the yield
curve is this steep is because of the US Federal Reserve has wrestled
down interest rates through various policy measures down and
controlled. Therefore, some argue that it is artificially steep.

Steepness of the Yield Curve
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this chart

The Fed & Politics Don’t Mix

Unfortunately for the Federal Reserve, it has come under attack from an
unprecedented number of critics that includes investors, economists and
even politicians. It has become good politics to take aim at the Fed
from both Democrats and Republicans energized by voters languishing
from the weak economy. For now, it seems as if The Fed has done about
all it can do for the economy. It seems as if Ben Bernanke is rolling
the world’s economic boulder up the hill all by himself. Some help has
to come from the White House and Congress. Therein lies the problem.

The level of debate and consideration of economic policy is at perhaps
a modern day low point and the markets have noticed. The debt ceiling
debacle in August shows how little the politicians seem to understand
the issues. Worse, some investors fear that perhaps they do understand
and are simply risking it all for political grandstanding with their
constituents. Part of the reason that Standard & Poor’s
stripped away the AAA rating of US government bonds is because they
could not see how the legislative process will produce a reasonable and
meaningful debt reduction strategy. In all honesty, whether the
politicians admit it or not, tax increases are going to have to be part
of the solution but spending cuts will have to be the lion’s share of
any reduction in debt and deficits.

Reasons for Confidence

In recent weeks, markets have taken
some confidence from economic data pertaining to jobs (steady),
manufacturing (expanding), credit spreads (holding) and retail sales
(rising). Though the markets are weighing the probabilities of a
recession, data would suggest measuring the odds of recession is more
difficult now.

Additional measures that should help the economy are a drop in oil
prices, fixing the disruption of the Japanese global supply chain
following this year’s earthquake, and a fall in global commodity
prices. This later will ease the inflationary pressures that have been
rising across the world. In recent weeks, some of the emerging market
nations have begun to cut interest rates again. Interestingly, China
and India remain vigilant on the inflation front whereas Brazil has
begun cutting interest rates.

When 2011 began, most strategists maintained a bullish outlook for the
year because the third year of a presidential term has historically
provided impressive stock market returns (see chart below), a
surprising U-turn in tax cut policy from the White House, and the
continued after effects from the Fed’s Quantitative Easing Program (QE
II) .

Presidential Cycle Chart
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this chart

The Challenges

From our perspective, our concerns were that QEII would have unintended
consequences, the economic data was continuing to surprise on the
downside and corporate profit margins were approaching the all-time
highs seen in 2007. Currently, corporate profits as a percentage of GDP
in the US are at an all-time high and maintaining these levels will be

As unemployment has continued to remain stubbornly elevated, wages as a
percent of GDP are at the lowest level since 1955 while corporate
profits are at the largest share of GDP since 1950. One reason that US
consumers have been reluctant to ramp up credit again is that they want
to pay down their debt levels and the statistics seem to bear this out.
As US consumers pay their debt down, Canadians have run up consumer
debt to alarming levels. Even the Organization for Economic
Co-operation and Development (OECD) has mentioned the debt levels of
Canadians as posing a challenge to Canada’s economic prosperity going
forward. Canadian debts have risen as incomes have remained largely

Likewise, for the US economy, The Economist magazine states that the
average US household has seen its inflation adjusted income stuck at
the levels of 1989. For the lowest income households, incomes are on
par with those of the late 1970s. This is in part due to low income
households tending to have lower levels of education that leave them
without the skills required to compete in a more globalized economy.

It should also be noted that US state and local governments have been
reducing their employment roles as they continue to work towards
reducing their own budget deficits. To help offset this, President
Obama has proposed a jobs bill, but it has little probability of
passing the Senate or the US House of Representatives.

European Woes

The risk priced into stocks reflects concerns about Europe and a
slowing global economy. The latter of these is all but priced into
equity markets. Investor confidence in European political leaders is
seldom overflowing – but the divisions amongst European politicians
prevent them from confronting their common challenges in a forceful

The debt crisis facing much of Europe has caused fear to ripple across
the globe. The decline in global equity markets has likely incorporated
the downside of a recession. By some measures equity markets are the
cheapest we have seen since the 1970s. By other measures, the market is
at worst fairly valued. Historically, recessions have brought about a
decline in markets and corporate earnings by approximately one third.

At this point, a moderate recession would be quite tolerated by the
markets. A significant, protracted economic decline would obviously
pose a challenge. It seems that the global economy has faced down some
significant challenges and continues to grind along at a somewhat
subdued pace but a recession could possibly be avoided as recent data
point out.

A resolution to the challenges facing Europe would lift the most
significant anchor weighing down upon the global economy. Germany and
France are leading European efforts to get a grip on the debt problem
but there is a significant disagreement amongst them. This comes from
the fact that French banks are much more exposed to European sovereign
debt than German banks and therefore, France wants to see a more
comprehensive solution to the crisis. At this point, Greek bonds are
priced for default. There is no way for Greece to payback the money it
owes – especially, as its economy shrinks under the IMF and EU imposed
austerity program.

Opportunities & Risks

As we have maintained a cautious approach since the turn of the year –
recognizing that the markets were likely under-appreciating the risks
going forward in 2011, investors must now begin to take stock of the
opportunities that the broad based global selloff in equities has
provided. While there are considerable risks to the macro landscape,
equity markets are showing the cheapest valuations in perhaps thirty
years. Not only is the market providing compelling valuations on a
price/earnings (P/E) and price/book (P/B) basis, stocks are providing
dividend yields that exceed Treasury bond interest rates – something
which has not happened since the early 1950s. The equity risk premium
is elevated such that investors are being compensated for taking risks
in equities. In short, risk should be on. The problem is Europe. This
muddies the waters to say the least.

In Summary

Stock market valuation indicators point to equities being attractively
valued and especially so relative to bonds. investors who favor bonds
to equities at current valuation levels may find that there is risk in
safety and thus, we believe that equities are the better alternative
for investors given the attractive valuations. For bonds to offer more
upside than downside from these levels would require a severe economic
decline and a deflationary undertone to the economy—something that the
data thus far does not support.

Partners – Capital Management

a Sea of Opportunity


This report is for information purposes only and is neither a
solicitation for the purchase of securities nor an offer of securities.
The information contained in this report has been compiled from sources
we believe to be reliable, however, we make no guarantee,
representation or warranty, expressed or implied, as to such
information’s accuracy or completeness. All opinions and estimates
contained in this report, whether or not our own, are based on
assumptions we believe to be reasonable as of the date of the report
and are subject to change without notice. Past performance is not
indicative of future performance. Please
note that, as at the date of this report, our firm may hold positions
in some of the companies mentioned.

Copyright (C) 2011 Pacifica Partners Inc. All rights reserved.

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